What Does A Dollar Really Buy?

STUDENT'S VERSION

INTRODUCTION

You hear the phrases on the news: "The CPI is up", "inflation is down." Though your first impulse may be to change the channel, the CPI is at least as relevant to most consumers' lives as the latest sports scores.

The CPI, or Consumer Price Index, is used to measure price changes in the economy. It is a measure of the average change in prices paid by urban customers for a "market basket" of goods and services. These goods and services include food, clothing, shelter, newspapers and CDs. Items on which the average consumer spends a great deal of money, such as food, are given more weight, or importance, in computing the index than items such as toothpaste and movie tickets, on which the average consumer spends comparatively less. As with any weighted index, the CPI probably won't match your own budget exactly. The increase in the CPI is what most people think of as the "inflation rate." It is used by retailers in predicting future price increases, by employers in calculating salaries and by the government in determining cost-of-living increases for Social Security.

TASK

In this lesson you will describe the purpose of a price index, explain how a price index is calculated, describe the weaknesses of the CPI, interpret CPI data as a measure of economic health, and identify who is harmed and who is helped by inflation.

PROCESS

Key Economic Concepts you will need to know:

Price index: a number used to measure the price level. The value of the index is set at 100 in the base year or period.

Consumer Price Index (CPI): the price index most commonly used to measure the impact of changes in prices on households. The index is based on a standard market basket of goods and services purchased by a typical urban family.

Inflation: the rate of upward movement in the price level for goods and services. By inflation economists mean a sustained rate of increase in the price level over time. Over the long haul, the fundamental cause of inflation is the growth rate of the money supply.

There is more than one way to construct a price index. The easiest to understand is probably the weighted average method. This method compares the total cost of a fixed market basket of goods in different years. To construct our price index, we will follow the steps below.

A) To construct any price index, some previous period is selected as the base year. We will use the total cost of the "market basket" in this year to compare with successive years.

B) The following table represents the total cost of a market basket in the base year of 1995. Choose a different base year and calculate the total cost of the market basket using the Consumer Price Index Calculation Machine
. Fill out the blank table in the market_basket.pdf. Then multiply the prices of the items in the basket by the average number of units purchased in that year; then compute the sum.

Market Basket
Food and Beverages

Year

Price

Quantity/Year

Price X Quantity = Yearly Cost

Loaf of Bread

1995

$1.28

70

$126.00

Bag of Apples

1995

$.50

40

$20.00

Gallon of Milk

1995

$2.54

104

$264.16

Jelly (12 oz)

1995

$1.52

26

$39.52

Cheerios (1 box)

1995

$2.71

60

$162.60

Carrots (1 pound bag)

1995

$.59

40

$23.60

Total Cost of Goods:

$635.88

C) Find the total cost of the market basket in the current year using the same approach.
Note: quantities will remain constant, only prices will change for this year.

D) The cost of the basic market basket in the current year is then expressed as a percentage of the cost
of the basic market basket in the current year, using this formula:

Index number (CPI) = Current year cost of
market basket/ Base year cost of
market basket X 100

[The multiplication by 100 converts the raw numbers to a percentage basis. The base year always has an index number of 100 since the current year cost and the base year cost of the market basket are the same in the base year.]

E) If we subtract the base year index of 100 from the index number we have calculated, we can
measure the percentage change in prices from the base year. (For example: a current year index number of 110 means a 10% change in price level from the base year)

Now that we have some background information, the real Fun can begin! Let's use what we have learned so far to construct our own CPI, following the steps below.

1) To keep things simple, identify just five items/services you purchase in a given year along with the quantity you purchase.
2) Locate the current prices of these goods /services.
3) We will use 1990 as our base year. Use the Internet (or other source) to locate the 1990 prices of the goods and services you have identified.
4) Apply the above formula to calculate the CPI.
5) What is the rate of inflation for your CPI?

Activity 3

What exactly does a dollar buy? The CPI is what most people think of as the "inflation rate." It is used by businesses, individuals and government use it to make important decisions. What does it mean to you? Let's use the CPI to see just how much inflation affects our lives.

To calculate a change in prices, we can use the formula from the example below:

How much would $1.00 worth of goods (or services) purchased in 1950 have cost in 2000?

CONCLUSION

Answer these questions:

What is the purpose of a price index?
How is a price index is calculated?
What are the weaknesses of the CPI as a measure of inflation?
What does a high/low level of inflation mean for the economy?
Who is harmed and who is helped by inflation?

ASSESSMENT ACTIVITY

Answer these questions using previous information:

What is the purpose of a price index?
How is a price index is calculated?
What are the weaknesses of the CPI as a measure of inflation?
What does a high/low level of inflation mean for the economy?
Who is harmed and who is helped by inflation?

EXTENSION ACTIVITY

As Rover delivers the morning paper, you see the following headline glaring at you.

"Inflation expected to rise…"

Wait! Don't throw it away! After all, this information is as important as the football scores. Take a minute to think about what that means to you.

Assignment: Write a brief reaction to this headline. Include, but do not limit your answer to, answers to the following questions:

How is inflation a measure of economic health?
What does this headline say about the current state of the economy?
How will this affect you or those you know? Who will benefit/who will be harmed?